Note: The article below was
subsequently edited by the author to reflect revisions in his paper as it
was later published in the Winter 2017 Virginia Law & Business Review.
For the revised article and a link to the published form of the paper,
click here.

Preferential treatment of investors is
more common than ever in today’s private equity industry, thanks to
new structures that make it easier to grant different terms to
different investors. For decades, private equity managers raised
almost all of their capital through “pooled” funds whereby their
investors’ capital was aggregated into a single vehicle, but recent
years have seen a dramatic increase in what I refer to in my paper as
“individualized investing”—private equity investing through separate
accounts and co-investments. Separate accounts and co-investment
vehicles are entities that exist outside and independent of pooled
funds, enabling managers to provide highly customized treatment to the
investors in them. Estimates are that upwards of 20% of all investment
in private equity went through these channels in 2015. Some anecdotal
accounts suggest much higher levels.

Many of the
largest and most influential investors in private equity have been
using these customized vehicles to negotiate for significantly better
terms and more robust rights than are available to pooled fund
investors. This raises a question that is both economic and
philosophical: is preferential treatment a good thing for private
equity? Should policymakers be restricting and regulating these
trends, or should they be left alone, or even encouraged?

For many
people, the idea of preferential treatment runs counter to a deeply
ingrained sense of fairness. My paper makes the case that, while
instincts favoring egalitarianism may be entirely appropriate—even
virtuous—in many contexts, they should not inform private equity
policy. When managers have free rein to bestow preferential treatment
as they see fit, the outcome is generally a more efficient marketplace
for private equity investment, with greater surplus available for
investors.

A bedrock
principle of the corporate governance literature is that when
conflicts of interest exist, they are only problematic insofar as they
lead to an appropriation of value from investors. The core
contention of my paper is that most forms of preferential treatment
enabled by individualized investing in private equity create new
value for the preferred investors who receive the favored
treatment, rather than appropriate value from non-preferred
investors. This logic applies to the following forms of preferential
treatment: superior customization of investment strategies and vehicle
structuring, superior rights to monitor and control the manager’s
activities, and superior fees. Individualized investing makes it much
easier for private equity managers to grant these kinds of
preferential treatment—indeed, these are the very reasons why so many
private equity investors have been seeking to form separate accounts
and make co-investments in recent years.

Importantly,
a darker possibility must also be considered. In addition to the
efficiency-enhancing forms of preferential treatment noted above, the
rise of individualized investing also makes possible a problematic
form of preferential treatment in private equity—one that does
involve an appropriation of value from non-preferred investors to
preferred investors. This form of preferential treatment—which I call
“inequitable allocation” in my paper—occurs when managers allocate
superior investment opportunities and other finite resources
disproportionately to separate accounts and co-investors and away from
pooled funds. Fortunately, as set forth in my paper, a close
examination of the incentives of private equity managers and investors
in today’s individualized industry reveals little risk of systematic
inequitable allocation when the market is competitive.

The most
important policy lesson from my paper’s analysis is one of regulatory
restraint. Even though preferential treatment has reached
unprecedented levels in private equity, and even though much of this
activity is taking place behind closed doors, policymakers should
avoid the temptation to over-regulate the practice. However, as the
shift toward individualized investing continues apace, an interesting
side effect emerges: the incentive for broad coordinated action among
private equity investors will grow weaker as their interests become
more individualized, making it more challenging for investors to
advocate for industry-wide standards and best practices. Information
disclosure is one example of an area where standardization can
sometimes be beneficial, raising issues in private equity that
resemble the classic debate in the securities literature over
mandatory disclosure by public companies.

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This Forum program is open, free of charge,
to anyone concerned with investor interests in the
development of marketplace standards for expanded access to
information for securities valuation and shareholder voting
decisions. As stated
in the posted
Conditions of Participation, the
Forum's purpose is to provide decision-makers with access to
information and a free exchange of views on the issues
presented in the program's Forum
Summary. Each
participant is expected to make independent use of
information obtained through the Forum, subject to the
privacy rights of other participants. It is a Forum
rule that participants will not be identified or quoted
without their explicit permission.

This Forum program was initiated to address
issues and objectives defined by participants in the 2010 "E-Meetings"
program relevant to broad public interests in marketplace
practices, rather than investor decisions relating to only a
single company. The Forum may therefore invite program
support of several companies that can provide both expertise
and examples of leadership relating to the issues being
addressed.

The information provided to
Forum participants is intended for their private reference,
and permission has not been granted for the republishing of
any copyrighted material. The material presented on this web
site is the responsibility of
Gary Lutin, as chairman of the Shareholder Forum.

Shareholder Forum™
is a trademark owned by The Shareholder Forum, Inc., for the
programs conducted since 1999 to support investor access to
decision-making information. It should be noted that we have
no responsibility for the services that Broadridge Financial
Solutions, Inc., introduced for review in the Forum's
2010 "E-Meetings" program and has since been offering
with the “Shareholder Forum” name, and we have asked
Broadridge to use a different name that does not suggest our
support or endorsement.